CHAPTER IX

BALANCE-SHEET AUDIT-ASSETS (Continued)

FIXED ASSETS

As distinguished from current assets, those more or less permanent with which the business is carried on are generally known as fixed assets. Instead of being offered for sale they are maintained, or renewed, and their use provides the means of carrying on the business.

Period to be Covered: Where an audit covers several years, or the entire life of the undertaking, an analysis of the items of fixed plant will be made in due course and the auditor will have before him all of the facts upon which to base an opinion as to whether or not the accounts represent fair cost of the existing assets. In a balance-sheet audit, however, the period to be covered usually rests with the auditor, and a serious question arises as to how far the book valuations may be accepted as a basis for actual values, assuming that the concern is to be valued as a going business, and that cost, less proper depreciation, is the result desired.

The auditor may as well accept the position here, as with inventories, that he is expected to report the facts about the plant account; where he cannot secure reliable information with respect to plant values he should state in his report that real estate, machinery, and similar assets are stated at book valuations. He should, however, attempt to ascertain whether these book valuations honestly reflect present conditions. His services are of little real value if such items are grossly overvalued and a net worth is shown which should be corrected by an intelligent use of evidence easily available by the auditor.

The auditor is charged with the duty of attempting to analyze the items of fixed assets as shown by the books to ascertain the principles upon which they have been created. In a few large enterprises an item of "plant" will appear which represents an aggregate valuation covering the purchase price of perhaps

the entire fixed property. It may be largely overvalued to offset common capital stock issued in payment therefor. In such cases, and in the absence of an appraisal of actual physical values, the problem is difficult and requires more detailed attention than can be devoted to it in a general treatise of this nature. The auditor, of course, cannot intelligently criticize such a valuation, even if it is absurdly excessive, unless he can secure an appraisal, approximate or actual. A statement that the plant is obviously greatly overvalued might lead bankers or others interested to call for an appraisement.

Auditors whose practice is chiefly with large corporations meet this problem frequently. Mergers and reorganizations lead to "lump" sums among fixed assets and any analysis thereof is out of the question. The records are not, as a rule, available, and if they were there would be so many changes in the principal items that the auditor would not be much better off. The property of large corporations is apt to depreciate or appreciate to a considerable extent; it rarely stands still. In the case of railroads the Interstate Commerce Commission desired an analysis of the property accounts of all roads reporting to it, but frankly gave up the problem and finally settled on the requirement that all additions subsequent to July 1, 1907, be analyzed in detail.

This course may be followed to advantage in industrial corporations. The lack of past data is no excuse for a continuance of poor bookkeeping, and the auditor who has any influence in the matter should request that intelligent analyses of all capital expenditures be preserved.

In many corporations the property accounts represent merely the securities issued and their actual value is not of prime importance to the auditor. He is greatly interested, however, in the operation and development of the enterprises and must assume the responsibility of classifying subsequent expenditure between capital and income.

In a great many balance-sheet audits data can be secured without much trouble which will show the component elements of the values, viz., the book cost of the various divisions of the plant and equipment accounts, whether the charges appear to include only items of additions and betterments, and if depreciation has been provided for.

In brief, in all balance-sheet audits the auditor must, if possible, secure an analysis of the existing book valuations, even if it is necessary to go back over the transactions of many

years.

The borrowers whose books do not lend themselves readily to an audit by professional accountants are usually the ones whose financial statements need serious scrutiny on the part of prospective lenders and creditors.

Value as a Going Concern: We are dealing with enterprises which are continuing in business, and of which a forced sale or liquidation is not contemplated, so that in attempting to fix the net value to a concern of its fixed assets we may say that, as a general rule, the correct basis is cost, less adequate depreciation for wear and tear and obsolescence.

It need not be considered that the dismantling of a plant or a forced sale under unfavorable circumstances would seriously disarrange the book values, provided the latter were based on the foregoing rule. This aspect of the case is well known to all who are interested, but no one, not even a banker, would contend that the balance sheet of a live enterprise should exhibit its assets at a "scrap" valuation.

Land and Buildings: Many auditors are too apt to take it for granted that real estate, a record of which appears in the books of accounts as owned, is actually the property of the business under audit, and that it is free and clear unless a mortgage also appears on the books. As a matter of fact, serious flaws have developed in the title to real estate which has been carried on balance sheets as an asset and which has been relied upon as a basis for credit.

This is not a difficult matter to cover, much easier, in fact, than many of the other items on the balance sheet of considerably smaller amount. The most practicable method, and one on which an auditor is entitled to rely, is to secure from the regular attorney or a title company a letter or certificate, properly signed, stating:

(1) Whether the title to the real estate as it appears, or is described, on the books is in the name of the individual, firm, or corporation whose name appears at the top of the balance sheet or in the auditor's certificate.

(2) That the said real estate is free and clear of any liens whatever, including the following:

(a) Mortgages.

(b) Judgments.

(c) Taxes, water rent, and other municipal liens.

While the foregoing liens, if disclosed, would appear among the liabilities, yet the place in an audit to cover this point is in connection with the verification of the asset side of the balance sheet.

It may be urged that an auditor should not depend upon the certificate of an attorney when there is no special difficulty in having a search of the public records made by his own staff, or by some one not connected with the enterprise, but in practically all cases the result would not be any more satisfactory, and in most cases difficulties present themselves which make it inadvisable for the auditor to attempt to assume the work of a lawyer.

An important distinction which must not be lost sight of is the classification of the real estate. A balance sheet should always show

(1) Real estate used in the business.

(2) Other real estate (if any).

This segregation applies to all concerns except those in which real estate is dealt in as a commodity. Taken in connection with the profit and loss account it shows at a glance whether the outside real estate is producing enough revenue to warrant holding it, and taken into consideration with respect to the indebtedness, it will afford an opportunity to decide whether it is wise to hold it indefinitely.

(1) Land: Land should appear in the balance sheet at cost, and should not be written up, although it may be clearly established that values have increased. As a matter of fact, an increment in the value of land usually means higher taxes, with no increase in earning power, so that the increased valuation is a detriment so far as current operations are concerned. The business does not receive any benefit therefrom except in case of a sale or a liquidation, and an adjustment of the book value need not be considered till these actually occur.

Similarly, if the land has apparently depreciated in value,

custom justifies the carrying of this item at cost until realization, at which time only can the actual value be determined.

A distinction must be made between improved and unimproved property. With the latter taxes and other carrying charges are sometimes added to the cost. The auditor should make a careful analysis of the items for use in his report. The facts speak for themselves so strongly that the auditor need do no more than refer to the items. All carrying charges, including interest, should be treated as revenue expenditures unless it is obvious that there is a continuous increase in the actual value of the property. When this is affirmatively shown, the carrying charges may be capitalized.

The largest realty company in the United States observes the following rule, as stated in its last annual report:

The company's real estate is carried on its books at its original cost. The entire expense of carrying the unproductive real estate is charged out of income, but in order to show the amount which the respective properties have actually cost us, this expense has been added to book value and a like amount has been set aside as a reserve.

This is conservative practice and is to be commended.

Where the auditor finds that an adjustment has been made increasing the book value of land, the fact should be noted on the balance sheet. Otherwise, a situation like the following may arise:

A corporation had accumulated an operating loss of about two hundred thousand dollars. Its land was within the limits of a large city and had obviously increased greatly in value, but no adjustment of the same had been made in the books. The company was at times a borrower up to about a million dollars, and the banks required periodical financial statements. The banks did not, however, require, and the corporation did not furnish, the certified statements furnished by the auditors (which exhibited the land at cost and the deficit mentioned above), but did furnish a balance sheet in which the land value was marked up several hundred thousand dollars-enough to wipe out the deficit and produce a surplus. As the land valuations were not excessive, the banks were not put upon notice that the company was losing money and that the books showed a deficit.